Sunday, April 22, 2012

Swaps regulation faces questions that should have been addressed 3 years ago

People often ask why it is taking this long to implement the new US derivatives regulation (part of the Dodd-Frank legislation). Well, it starts with zealous politicians who know all about the province of Kandahar in Afghanistan (because they are all about the "war on terror"), but know little about the global banking system or what a swap is for that matter. Then the implementation gets turned over to domestic regulators such as the SEC and the CFTC who themselves don't fully understand international banking. The CFTC had enough trouble regulating MF Global - and now they are asked to deal with Deutsche Bank's London subsidiary? The SEC has hundreds of hedge funds to register and audit while they can't even implement proper disclosure rules for public companies. It's no wonder that confusion has overtaken this derivatives regulation implementation.

Here are some basic questions that should have been addressed when the rules were designed, not during the implementation process.

Example 1: A US bank subsidiary doing derivatives business in the EU.

If a US domiciled bank owns another bank in the EU jurisdiction, does this other bank need to comply with the US rules? If yes, how would it compete with other banks in its jurisdiction that are not owned by a US bank? If no, the US bank would simply move some of it's derivatives business to the EU subsidiary to get a better regulatory treatment. Would the EU be able to synchronize its derivatives regulation with the US (to take out the loopholes) when EU members can hardly agree with each other? How long will it take?

Example 2: An EU domiciled bank owns a US subsidiary.

Clearly the US subsidiary will need to comply with the US rules. But should the parent bank as well? If yes, than the CFTC/SEC would have jurisdiction in the EU, really annoying EU bank regulators. If no, then how is JPMorgan to compete with Deutsche Bank within the EU when they are under different regulatory frameworks.

FT: US banks including JPMorgan Chase have warned that if their overseas subsidiaries are forced to adhere to US rules, they risk losing business to the likes of Deutsche Bank and Barclays. But foreign banks have warned that the language of US rules could subject them to worldwide supervision by US authorities.

Example 3: A US bank subsidiary doing derivatives business in the EU with an EU based client.

A derivatives client generally doesn't care where she executes a swap. A US based client for example could and often does execute swaps with a London-based bank (which may be a subsidiary of a US, a German, or a Swiss bank). A bank subsidiary is Brussels or Zurich could do just as well. Should there be a difference between US based clients and foreign based ones? What do you do with a hedge fund client domiciled in the Caymans? Nobody is even talking about Hong Kong or Singapore based subsidiaries with their own set of regulations and loopholes.

FT: ... the CFTC is examining whether a US bank’s foreign subsidiary transacting with foreign counterparties should be exempt from some new rules governing derivatives dealers if the subsidiary’s home country financial supervisors adopt robust oversight. A foreign bank’s derivatives desk also may be exempt from US rules if its national regulator employs rules closely mirroring those of the CFTC.

The CFTC is now under so much pressure in trying to resolve some of these issues, the agency has decided to postpone imposing some of the new rules on entities that are in foreign jurisdictions. Of course that includes the London swaps desks of JPMorgan for example - which basically means business as usual in London?

FT: The US Commodity Futures Trading Commission is looking to grant a temporary exemption to swap dealers that may fall under the jurisdiction of foreign financial authorities from complying with a host of post-financial crisis regulations governing derivatives transactions, people familiar with the matter said.

Confused enough yet? Well, seems so is the CFTC. Realizing the scope of the problem, the agency decided it is overwhelmed enough implementing the rules for the largest dealers. For now it simply can't deal with hundreds of smaller derivatives players.

Reuters: The CFTC originally said in December 2010 that firms would be counted as swap dealers if they traded more than $100 million in swaps over a 12-month period [numerous hedge funds trade 10 times that in a year].

That threshold set off a desperate push by energy companies and big commodity traders, who argued that they are using trades to hedge against market risks, and that their exposure does not endanger the broader financial system.

The final version released on Wednesday bumps the threshold up to $8 billion for most asset classes as an initial phase-in. Eventually, that threshold drops to $3 billion, unless regulators decide a different threshold is appropriate.

It was easy in 2009 to "regulate it all, ask questions later". Now the questions are being asked and the answers are not easy to come by. Some of this regulation will be so convoluted and confusing, it may create more risks than it originally intended to address. And as before, the dealers will find some loopholes because they can always afford better lawyers and structurers than the CFTC.